Sunday, March 18, 2012

How much Iran premium in oil prices is justified?

The folks at Capital Economics believe that there is too much "Iran premium" built into crude oil prices. They argue that the oil markets have gotten ahead of global growth. And with global growth expectations overdone, the premium is now mostly due to the Iran disruption risk. So the question becomes is the Iran premium built into oil prices too high?

The chart below compares trends in equity prices vs. Brent crude. It does seem to indicate that there may be a material gap between the two with oil prices overshooting. Based on this chart, Brent should be some $5 -$10 cheaper. That would not represent a high Iran premium.

Source: Capital Economics

The second chart compares the global manufacturing PMI index with percent changes in oil price. This seems to indicate that global manufacturing is still materially below recent averages, while oil price increases have been strong. Based on this, the premium in crude prices is even higher. Capital Economics argues that the Iran premium is therefore between $5 and $25 (not a very helpful range). And according to them the premium is overdone.

Source: Capital Economics

But in spite of this argument, a disruption causing an oil price spike remains a major risk to an already tepid global growth . It is therefore entirely possible that oil can now act as a hedge to a portfolio that may be vulnerable to such a disruptions (equities, credit, etc.). Some of this excess premium may therefore be justified because of crude's utility as a hedging tool.